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Investing in Municipal Bonds

A corporate debt issue
Source: sxc.hu Photo: Logan

One of the hot topics of discussion lately is that of municipal bonds (also called munis). Recently, superstar investor Warren Buffett warned that they could be facing trouble in five to 10 years if the federal government doesn’t step in to help. On the other side, though, are those who see municipal bonds as a way to generate some solid income from the payments they receive. Here are the basics of investing in municipal bonds:

What are Municipal Bonds?

Municipal bonds are bonds issued by cities or agencies below the state level. You essentially lend the municipality money, and in return you receive regular interest payments, and you get your principal back. However, like any bond investment, there is a chance that the issuer will default, meaning that you lose your principal and end up only with the interest you have received so far.

In general, municipal bonds are considered riskier than U.S. Treasury securities. Municipal bonds also generally offer higher yields. Since these bonds are considered a less risky that stocks and some other investments, many investors find municipal bonds a nice compromise between Treasury bonds and stocks.

Municipal bonds are generally divided into two main classifications:

  1. General obligation bonds: These bonds issued by the municipality for a variety of different items that fund the running of the city government. The principal and the interest are supported by the taxing power of the issuer.
  2. Revenue bonds: These are bonds that are secured in revenues from specific projects, such as subsidized housing, toll roads, sewage facilities and other projects that are expected to pay back the revenue raised to fund the project.

There are other types of municipal bonds as well, including assessment bonds and private activity bonds. Many consider general obligation bonds to be the least risky of municipal bonds, since they are often voter approved, and do not rely on the revenue created by the project. As a result, the yield on most general obligation municipal bonds is often lower than the yield on other types of municipal bonds.

Muni Bonds and Taxes

One of the reasons that many investors like municipal bonds is the tax advantages that can come with some types of bonds. In addition to providing a potential source of income, municipal bonds are often tax free in terms of federal taxes. The earnings from most municipal bonds will not subject to any federal taxes, and many states will not collect taxes on many types of municipal bonds.

The main exception to this rule is some municipal bonds issued for specific purposes (another reason some investors prefer general obligation bonds). There are certain bonds issued for specific projects that are subject to the alternative minimum tax. Many private activity bonds are municipal bonds issued that benefit mostly private parties, and these are often subject to federal income tax. Before you invest in municipal bonds, for income purposes or any other reason, it is a good idea to check the bond. Most bonds are certified as either tax-exempt or taxable, and you can find out if you are interested in limiting your tax liability.

How to Invest in Munis

You cannot go to a central place to purchase municipal debt. You can buy directly from brokerage firms, though. One way to do this is to look for a brokerage firm in the area you are interested (maybe even your own home town), and ask about municipal bonds. Commissions on municipal bonds are usually figured as a percentage of the investment. Most municipal bonds are issued in denominations of $5,000, or multiples of $5,000. You can double check with the municipality of interest, though, to find out about other possibilities.

In addition to buying directly, you can invest in municipal funds. It is important to understand, though, that you can lose a lot of your already somewhat low yield to management fees. There are also closed-end bond funds that trade in a manner similar to an ETF. The main advantaged to closed-end bond funds is that they are often sold at a discount, and so many in retirement view them as a good value.

Bottom line: Many investors like municipal funds for their potential to generate stable income. However, there are some risks associated with bonds, and you should examine your options, and perhaps consult with a professional before investing. Double check whether or not your municipal bonds are tax exempt before investing.

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